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INTRODUCTION

The bills described in this pamphlet have been scheduled for a public hearing on September 25, 1981, by the Senate Finance Subcommittee on Taxation and Debt Management.

There are four bills scheduled for the hearing: S. 578 (relating to inventory writedowns and LIFO inventories); S. 768 and S. 1472 (relating to exclusion of research expenses from capital expenditure limitation on interest exemption for small issue industrial development bonds); and S. 1276 (relating to inventory writedowns).

The first part of the pamphlet is a summary of the bills. This is followed by a more detailed description of the bills, including present law, issues, explanation, and effective dates.

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I. SUMMARY

1. S. 578 (Senators Moynihan, Melcher, Eagleton, East, Williams, Baucus, Inouye, and Sarbanes), and S. 1276 (Senators Durenberger, Melcher, Boschwitz, Zorinsky, and Grassley):

a. Section 1 of S. 578 and S. 1276-Inventory Writedowns Present law

For income tax purposes, inventories are used as a method of determining the cost of goods sold and hence a taxpayer's gross income from the sale of goods. Under present law, a taxpayer may "write down" the value of its inventories (thereby decreasing gross income in the year of writedown) if the taxpayer uses the lower of cost or market method of inventory accounting or, in the case of "subnormal" goods, if the goods are actually sold below cost within a relatively short period after the inventory date (Reg. § 1.471-2(c)).

In 1979, the U.S. Supreme Court upheld the disallowance of inventory writedowns which failed to comply with these Treasury regulations, on the ground that such writedowns fail to clearly reflect income (Thor Power Tool Co. v. Commissioner). Subsequently, the Internal Revenue Service issued Revenue Procedure 80-5 and Revenue Ruling 80-60 to implement the Thor Power decision.

S. 578, Section 1

Section 1 of S. 578 would allow a taxpayer to write down portions of inventories to net realizable value based on a five-year average of items in that inventory that were disposed of at less than cost. This provision would apply to taxable years ending on or after December 25, 1979. S.1276

S. 1276 would allow a qualified small business to write off one-third of inventory held for more than 12 months, 50 percent of inventory held for more than 24 months, and 100 percent of inventory held for more than 36 months. This provision would apply to taxable years beginning after December 31, 1980. Also, S. 1276 would delay the effective date of Rev. Proc. 80-5 and Rev. Rul. 80-60 to taxable years beginning after December 31, 1980.

b. Sections 2 and 3 of S. 578-LIFO Inventories

Under present law, taxpayers that elect to use the LIFO method of accounting for inventories must use LIFO for purposes of their financial statements (sec. 472). Also, taxpayers electing LIFO must include in income inventory market writedowns taken for inventories that remain unsold. Under the Economic Recovery Tax Act of 1981, this income is to be taken into account ratably over the three-year period beginning with the taxable year of the LIFO election.

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Section 2 of S. 578 would allow taxpayers to use LIFO accounting for tax purposes regardless of the method of inventory accounting used for purposes of financial statements. Section 3 of the bill would extend the three-year recapture of inventory writedowns to ten years. The provisions of sections 2 and 3 of the bill would be effective for taxable years beginning after the date of enactment of the bill.

2. S. 768-Senator Moynihan, and S. 1472-Senator Denton

Exclusion of Research Expenses From Capital Expenditure Limitation on Interest Exemption for Small Issue Industrial Development Bonds

Present law

Interest on certain State and local industrial development bonds is exempt from Federal income tax, pursuant to an exception under present law for "small issues," where the aggregate amount of outstanding exempt small issues plus capital expenditures (financed otherwise than out of small issue bond proceeds) does not exceed $10 million (Code sec. 103 (b) (6)). Because research and experimentation expenditures are considered to be capital expenditures, such expenses are to be taken into account in determining whether the $10 million limitation is exceeded, whether or not the taxpayer elects to deduct currently or amortize research expenses under Code section 174 (Rev. Rul. 77-27, 1977–1 C.B. 23).

S.768

Under the provisions of S. 768, research and experimental expenditures (within the meaning of sec. 174) would not be taken into account for purposes of the capital expenditure limitation on small issue industrial development bonds. The bill would apply to obligations issued after the date of enactment, and also to capital expenditures made after December 31, 1980.

S.1472

Under the provisions of S. 1472, research or experimental expenditures which the taxpayer elects to deduct currently under section 174 (a) would not be taken into account for purposes of the capital expenditure limitation on small issue industrial development bonds. The bill would apply to research or experimental expenditures paid or incurred after March 11, 1981, with respect to obligations issued after that date.

II. DESCRIPTION OF BILLS

1. S. 578-Senators Moynihan, Melcher, Eagleton, East, Williams, Baucus, Inouye, and Sarbanes, and S. 1276-Senators Durenberger, Melcher, Boschwitz, Zorinsky, and Grassley

a. Section 1 of S. 578 and S. 1276-Inventory Writedowns

Present law

Background

Gross income from the sale of goods equals gross sales receipts less the cost of goods sold. The computation of cost of goods sold is made by taking the beginning inventory, adding the purchases made during the year, and subtracting the ending inventory. The resulting amount is the amount of goods that were disposed of during the year and are presumed sold.

The dollar value of the ending inventory is determined by actually counting the goods on hand at the end of the year and then ascribing a value to those goods. The valuation method is important because a higher value will result in a lower cost of goods sold and thus greater taxable income, while a lower value will result in a higher cost of goods sold and thus lower taxable income. For example, a decrease or "writedown" in closing inventory increases the cost of goods sold for the year of writedown, and hence reduces gross income.

For Federal income tax purposes, Code section 471 requires a taxpayer to account for inventories in a manner that conforms as nearly as possible to the best accounting practice in the taxpayer's trade or business and most clearly reflects the taxpayer's income. Treasury regulations provide that the two most commonly used bases for valuing inventories which satisfy these requirements are (1) cost and (2) the lower of cost or market (Reg. § 1.471-2(c)).

A taxpayer using the latter method is permitted to write down the value of inventory items from the cost of the items to market value. (In general, the market value of merchandise is the bid price prevailing in the marketplace for the goods.) In addition, a taxpayer using the lower of cost or market method may write down inventories to below market value if, in the regular course of business, the taxpayer offers merchandise for sale at less than the prevailing market price. If actual sales are made at prices which do not materially vary from offering prices, the goods may be written down to the offering prices, less any direct costs of disposition.

Taxpayers using either the cost or lower of cost or market method of valuation may write down subnormal goods (goods which cannot be sold at normal prices because of damage, imperfections, shop wear, and similar infirmities) to a bona fide selling price, less direct costs of disposition. The bona fide selling price is defined as the selling price at which the goods are actually offered for sale during a period ending not later than 30 days after the inventory date (generally, the taxpayer's year-end).

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